Federal Reserve issues new restrictions on crypto banking services

The Federal Reserve Board warned its member banks that it intends to presumptively ban a large portion of cryptocurrency banking, as demand for more guidance on digital assets has grown following widespread cases of fraud.

Outlined in a final rule published on Tuesday, the Board of Governors of the Federal Reserve System offered an interpretation of section 9(13) of the Federal Reserve Act to govern the use of digital assets in the federal banking ecosystem. This section specifically applies to rules established by the Federal Reserve for member banks, which dictate the banking activities state depository institutions are legally able to perform, as only what is also permitted for national banks.

Federal Reserve member banks consist of state-level financial institutions that meet the operational requirements of the Federal Reserve System and are supervised by the 12 designated regional banks across the United States

The rule provides two directives under the Federal Reserve’s existing laws: that the board will “presumptively prohibit” member banks from holding most crypto-assets, and that member banks wishing to use dollar tokens must prove certain security measures and receive formal approval prior to use in banking transactions.

Both rules cite the “significant risks” associated with the cryptocurrency sector, including fraud, legal ambiguity and volatility.

“With respect to new and unique activities, such as those related to cryptoassets or the use of distributed ledger technology, it is particularly important for a state member bank to have in place appropriate systems to monitor and control risks,” the rule states. , noting the ways in which most digital assets inherently prevent banks from ensuring such security.

“The board believes this assumption is supported by considerations of safety and soundness,” notes the board. “The Financial Stability Oversight Council has observed that, in the absence of a fundamental economic use case, the value of most cryptoassets is largely driven by sentiment and future expectations, and not by cash flows from providing goods or services outside the cryptoasset ecosystem.”

The final rule continued that the volatility of most decentralized digital assets prevents financial institutions from taking the necessary risk management procedures associated with other forms of capital. In addition, the inherent anonymity of cryptocurrency user transactions also poses security risks, especially along distributed ledger technologies such as blockchain.

Despite largely agreeing that the use of digital assets in the US banking system poses security threats, the board offered some options for potential incorporation.

The final rule notes that issuing dollar tokens along decentralized ledgers was also likely to be insecure. However, member banks are eligible to receive a “regulatory no-objection” from the board provided they can demonstrate the ability to conduct secure banking with dollar tokens.

Commonly referred to as stablecoins, dollar-denominated tokens differ from traditional cryptocurrencies in that they are pegged to the US dollar, thus presenting a lower risk of price volatility. Distributing dollar tokens along a distributed ledger software still poses a significant amount of cybersecurity and operational risk, according to the board, namely among illegal financial activity.

“The board generally believes that issuing tokens on open, public and/or decentralized networks or similar systems is highly likely to be inconsistent with safe and sound banking practices,” it said.

This decision opens a new chapter in the regulatory battle regarding digital asset and the crypto industry. President Joe Biden recently issued an executive order spurring more research into cryptocurrencies’ effect on the broader economy, and money laundering via digital assets amid the ongoing Russia-Ukraine war has put a spotlight on the security risks within the new technology.

The board’s final rule regarding government banking operations with digital assets diminishes hopes of incorporating cryptocurrencies into the regulated economy, and is consistent with other recent actions by the Federal Reserve. In late January, the agency rejected digital asset transaction firm Custodia Bank for membership as a subsidiary bank.

“Custodia actively sought federal regulation, going beyond all requirements applicable to traditional banks,” the bank said in a statement. “The Board’s denial is unfortunate, but consistent with the concerns Custodia has raised regarding the Federal Reserve’s handling of its applications, an issue we will continue to address.”